With the start of the football season, be sure to watch Ron Heller, CEO of Peritus Asset Management and Super Bowl XXIII winner, as he is a guest on Bloomberg TV on Wednesday, September 3rd, 2014 at 4:40pm ET to discuss markets and the start of the NFL season.
Tim Gramatovich was interviewed by TheStreet in a segment entitled, “Massive Outflows Do Not Spell Doom for High Yield Market” on Thursday, August 14, 2014.
Peritus’ Tim Gramatovich will be a guest on Bloomberg TV’s “Street Smart” on Wednesday, August 13th at 3:45pm ET and Business News Network’s “Business Day” program on Thursday, August 14th at 3:50pm ET.
What is risk and how is it defined? To us, risk is about losing money and managing risk is what portfolio management is all about. Let’s begin with credit risk, which is something we take on and expect to get paid for. First of all, credit investing is a negative art. What you don’t buy is more important than what you do buy. Investors will not appreciate this until the cycle turns, which will inevitably happen at some point.
What are we looking to avoid? The common answer is defaults. But this is not entirely accurate. We can make money if a company defaults assuming that the perceived recovery of the bond or loan is higher than what we paid for it. Let me be clear: we are not buying distressed assets in the hope of making money; this type of vulture investing is very specific. We are in fact looking to avoid defaults and losses.
But just how do we seek to avoid defaults, or more accurately seek to avoid losses? Let’s look at the negative first. Here is generally what we don’t like:
- Companies that use cash and don’t generate it.
- Businesses that have a lack of liquidity.
- Enterprises that are highly levered with lack of free cash flow growth.
- A product or service that is non-essential.
- Buying bonds/loans priced well above their call prices (negative convexity).
- Bonds/loans issued for “bad” purposes such as dividends to private equity sponsors.
- Bonds that do not pay cash interest, such as PIKs (pay-in-kind) or PIK toggles.
While this seems pretty straight forward and sensible, it is remarkable to watch these disciplines get thrown out the window in the chase for yield. These errors are glossed over when capital markets are wide open, but get magnified when they close up. On the positive side of the ledger, here is generally what we like:
- Companies that generate true free cash flow (cash flow from operations less normalized capital expenditures).
- Businesses that have excess liquidity in the form of cash and/or bank line availability.
- A company selling a product or service that is considered a consumer essential.
- Recurring/contracted revenue streams.
- Buying bonds at discounts to par or call prices.
All of this seems pretty straight forward and much of it is pitched by other value investors. Execution of this (holding one’s discipline when everyone else is waving it in) is much tougher to do than to say. More difficult yet is real “alpha” generation, which involves buying what is believed to be undervalued securities with the goal of generating excess yield and/or capital gains. Most of what we have said above is related to business fundamentals. That is only the first step in the process. We then have to look at the price of the securities (loans/bonds/equity) that represent the investment. Investing is a non-linear art form. Our job is to ferret out those securities we believe are “mis-priced.”
There are a number of reasons securities become mis-priced including, but not limited to, the following:
- General industry unpopularity
- Asset class unpopularity
- Quarterly earnings miss
- Poor forward guidance
- Product or cost pricing issues
Our analysis must determine that whatever factors caused the “mis-pricing” are not serious enough to cause impairment or default and they are temporary. Each business must be analyzed independently and an assessment has to be made of where the best value lies in the capital structure. The high yield and floating rate loan markets are large and growing markets, with what we see as attractive opportunities for active managers who are able to look for value and identify potential mis-priced securities within a company’s capital structure.
Eyebrows have been raised recently about the sustainability of dividends in the energy sector as more and more companies adopt a dividend paying model, be it Master Limited Partnerships (MLPs) or traditional equities that pay dividends. Some believe exploration and production (E&P) companies may be adopting a dividend-paying structure simply to increase their stock price. While this assumption may be a bit aggressive, it is important to note that capital often becomes more accessible for dividend paying equities. Caution must be exercised in dividend investing to avoid the downward spiral of a dividend cut or even elimination.
One of the most important fundamental drivers when analyzing the sustainability of a company’s dividend is internally generated, truly distributable cash flow. Internally generated cash flow for these E&P companies is a combination of production and the “cash netback” (think of this as the cash margin per single barrel of oil after all costs are taken into account). Netbacks can be affected by many different factors and we are not just looking for the highest netback on an absolute basis. For example, companies who produce a lighter blend of oil will most likely have a higher netback as the realized price is greater than that of heavy crude, so comparing the two on an absolute basis could show a substantial difference. Netbacks are also affected by costs such as operating, transportation, royalties and interest on debt. Not only does high interest expense decrease the cash netback, it also means higher leverage, potentially introducing more volatility (risk). As we analyze potential dividend paying equities, we look for companies with low leverage, as they likely have the ability to grow by raising outside debt capital, as well as those producing more current operating cash flow via higher cash netbacks. We prefer companies who have a competitive advantage embedded somewhere in their netback, which may include, but not limited to, operational efficiencies, easy access to transportation and/or favorable hedging strategies.
So once we have analyzed and are comfortable with internally generated cash flow, how can we be comfortable with the current dividend? The main ratio we look at is called the sustainability ratio (or total payout ratio) which is calculated as (capital expenditures plus dividends)/ cash flow from operating activities. This ratio displays the company’s ability to fund the dividends from its operating cash flow, while still being able to develop its asset base via capital expenditures. We are looking for this ratio to be under 100%, which means the dividend and capital program are funded from operating cash flow, giving us a sustainable business model.
If a company has a DRIP program (dividend reinvestment program, whereby shareholders are paid out via more shares rather than cash), we also need to be aware of the percentage of shareholders making use of the program. The higher the percentage of shareholders reinvesting their dividends, the less actual cash distribution. While positive from a cash standpoint, we also need to see if the bulk of the dividend is being paid in non-cash form and if that is actually sustainable if the DRIP election were to change. Therefore when we are looking at sustainability ratios net of DRIP, for example, (capital expenditures plus dividends less DRIP)/ cash flow from operating activities, we must also run the ratio excluding the DRIP program as if the dividend was 100% cash-pay. While a DRIP program is by no means a negative sign, a company without a DRIP program shows conservative corporate governance and the fact that management is not overstretching to fund a dividend. Analyzing the simple payout ratio (dividends/ cash flow from operating activities) is also key as it shows how much flexibility the company has in its capital program.
All E&P companies face challenges and production is a constant battle. One reason we especially like certain Canadian E&P dividend paying equities is the generally respected nature of their dividends along with the flexibility of their capital program. Because Canada has a very nascent high yield market, companies often need the equity market to raise capital. As such, many of these companies pay out what we see as significant yields to attract investors and often treat their dividends in the same manner as an interest payment. In many cases, they recognize their dividend payments are extremely valuable and will do almost anything to protect them.
In terms of the flexibility of the Canadian E&P’s capital program, if a company runs into trouble with production, this will mean less cash flow (production * cash netback = cash flow), but they will easily be able to scale back their drilling program to keep the dividend intact. Clearly they cannot keep missing production guidance and scaling back capex, but the simple payout ratio gives us a feel for how far they can miss production estimates. Two other very important things we look for to mitigate this problem are low decline rates and large reserve life indexes (RLIs). A low decline rate means you can produce oil for a longer period of time without having to drill more holes. A reserve life index is the hypothetical number of years it would take to deplete a company’s reserves at current production rates. Combining both of these qualities means less drilling activity needs to take place to keep production constant.
Yield-based investors must focus on the sustainability of that yield, be it a company’s interest payments or dividends. While there are some seemingly attractive opportunities in exploration and production companies, especially Canadian-based producers, investors need to understand the company’s financial dynamics to assess that residual cash flow availability to service these payments and the ultimate dividend sustainability.
With this week’s 4.0% GDP number and FOMC meeting statement, concern seems to re-emerge that rates will be headed higher in the near-term. The Fed has said that they will keep rates low for a “considerable time” once the asset purchased have been eliminated, presumably by the fall off this year. However, some speculate that there is enough of an improvement in the underlying economy that this move up is coming soon.
It seems premature to say that the 4% initial number in Q2 is a sign of a sustained improvement versus just a bounce back after an incredibly weak Q1, especially with 1.7% of the gain attributed to an inventory build and all of the GDP revisions we have seen of late. And as Yellen indicated this week in the statement, slack and “underutilization of labor resources” remains. Not to mention that the geopolitical risks seem to be escalating daily, be it Russia, Argentina, or the Middle East, which will likely hamper global growth further.
So while it is not clear to us that an increase in the interest rates that the Fed controls is on the nearer-term horizon, the Fed will likely move at some point in the next year or two. But just because the Fed will start to raise rates at some point in the future, that doesn’t mean that we see a big move up in rates across the board, especially the longer maturities (5-30 year Treasuries) versus shorter term rates. There are other forces at work impacting interest rates. One of these major forces we are starting to see at emerge, and we expect to become more of a factor in the years to come, is demographics: with an aging populations, we see the demand for yield-based securities accelerating.
As we recently explained in our piece “Of Elephants and Rates,” demographics are destiny and the shift into fixed income from equities is in the beginning innings; rather than the “great rotation” from bonds into stocks as many have argued. The following chart and quote from Morgan Stanley sum it up nicely.1
Published by Morgan Stanley Research on October 8, 2013
Ageing demographics mean regular income, capital preservation and lower volatility are key
We expect that ageing demographics will subdue the strength of this rotation relative to history and will drive convergence between the Retail market and the retirement market. The reduction in equity allocations for the >60 age bracket over the past decade (based on ICI data for the US market) plus the ageing demographic (consultants estimate that within five years nearly 75% of Retail assets will be owned by retirees or those close to retirement) clearly call into question the sustainability and strength of this rotation back into equities. By the end of the decade, the weight of Retail money will be in decumulation phase, as it is in Japan today. We expect that regular income, capital preservation and lower volatility outcomes will be the key focus of this investor group.
Published by Morgan Stanley Research on October 8, 20132
The bottom line is that the “decumulation” phase is just beginning in most developing countries. The statement that within 5 years, nearly 75% of retail assets will be owned by those retired or near retirement is almost shocking. Just how much of the world’s assets are held by retail? Morgan Stanley recently released a report estimating that approximately $89 trillion of investible assets exist globally and of that about 60% is institutional and 40% retail.3 This translates to approximately $36 trillion in retail assets globally. Those at retirement age in all countries don’t care about Ibbotson charts or expected returns. They want tangible income and principal protection.
The demand is also there on the institutional side, with institutional investors now beginning their aggressive move toward LDI (liability driven investing). LDI is being used not only by insurers, but now by the global defined benefit (“DB”) plan market. Keep in mind that defined benefit and defined contribution pension plans encompass a significant portion of that 60% of global investible assets that is attributed to institutions. As equities have soared over the past five years, many of these large DB plans have seen their funding ratios come close to 100%. Originally, our thinking was that these plan sponsors would continue to “game” pension accounting keeping equity allocations high. What we mean is that pension accounting involves manipulation; “expected returns” of asset classes based on historical numbers enter into the way DB plans have to fund their liabilities. Plan sponsors seem to be choosing LDI as a way to “immunize” this liability rather than roll the dice with equities.
LDI is similar to banks running a fully hedged book. When interest rates rise, the present value of pension plan liabilities fall. But of course when rates rise, many bond prices fall offsetting the liability gains. Conversely, when interest rates fall the present value of liabilities rise offset by a gain in bond prices. Ultimately it is expected that the desire for those running U.S. pension plans to match liabilities will encourage “de-risking,” moving away from equities into the fixed income realm. We have already seen evidence of this de-risking globally.4
Published by Morgan Stanley Research on October 8, 2013
For instance, in the United Kingdom, equity allocations have fallen from 68% to 39% over the last decade, and could ultimately fall as low as 10% for defined benefit plans.5
Published by Morgan Stanley Research on October 8, 2013
So the much discussed great rotation from fixed income into equities makes for nice headlines, but the actual numbers look to be far from reality as the demand for fixed income securities heats up globally, including here in the US.
Furthermore, on a yield front, the US looks attractive relative to the rest of the world. Our 10-year is yielding about the same as those sovereign bonds of the likes of Italy and Spain. Which would you believe is a more credit-worthy country? Our rates are more than double those of countries such as German and Japan.6
|Country||10-Year Bond Yield|
Fed policy, as well as supply and demand dynamics all pay into actual interest rates. As we look forward, demand for bonds and other fixed income asset classes is coming from both the retail and institutional investor and that demand is expected to accelerate as the trend of de-risking away from equities and into fixed income moves firmly into place. And we are already seeing a strong demand for bonds above and beyond the Fed. For instance, the bid-to-cover ratio for the longer-term bonds has been nearly 3:1 in 2014. So while the Fed may ultimately start gradually taking rates up over the next couple years, we expect the demand for Treasuries and other fixed income securities to remain strong, and even accelerate as demographics become more of a factor. We would expect that this, along with the economic headwinds and global dynamics, will constrain rates going forward.
1 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 13.
2 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 20.
3 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 15.
4 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 17.
5 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 18.
6 Data sourced from Bloomberg, as of 8/1/14.
We believe that the best approach to credit investing is to be agnostic on the credit ratings. This ratings agnosticism is central to our investment philosophy and process. We believe that credit ratings have created inefficiencies in corporate credit and an opportunity for those willing to step down on the ratings spectrum. Credit ratings tend to be backward looking algorithms that favor the size and longevity of a business. The reality is that we are lending money to companies today and care about the future. As such, historical ratings are interesting, but we believe not particularly relevant. Think of equities: how many investors consider issuer/credit ratings for a company when they buy its stock? If you are buying the most junior piece of the capital structure and don’t consider them, then why is so much emphasis placed on ratings for bond investors?
What I have seen in 30 years is that many investors continue to avoid bonds and loans rated below BBB (the dividing line between investment grade and non-investment grade) which is what creates the first structural inefficiency for the high yield market and can allow us to generate potential alpha. What is mind numbing to me is that we have now gone through two “nuclear winters” (2002 and 2008) and the absurdity of credit ratings were at the core of both. Do you remember what the ratings for Worldcom and Enron were just before they filed for bankruptcy and set the world on fire? Investment grade! How about the 2008 meltdown? Weren’t Moody’s and Standard and Poor’s at the center of the flame with their AAA ratings on sub-prime Collateralized Debt Obligations (CDOs)? It was so bad that government intervention and even legislation was pursued to remove credit ratings for bank and insurance determined capital ratios. It never happened and all just quietly died. Yet some investors continue to invest by and are beholden to this ratings process, which we view as limiting and potentially misguided.
Once investors migrate below investment grade, there is a further bi-furcation in high yield, as many players pitch what we like to call the “cream of the crap” story. In essence, they will buy only BB rated securities. Again, an investment process that is being dictated by rating agency black boxes. We would argue that a portfolio of BB securities today could quite possibly be the worst of both worlds: you are still exposed to credit risk yet generate minimal yield. Additionally, many BB securities trade like investment grade, meaning they are often very sensitive to changes in interest rates and may have much longer durations given their lower yields.
No diatribe on ratings would be complete without a little chat about investment grade corporate bond markets. Investment grade is defined by Standard and Poor’s as BBB- and higher, while Moody’s defines it as Baa3 and higher. I have been in the leveraged finance business for 30 years. I cannot tell you the fundamental difference between a BB+ credit and a BBB- credit, yet one is “investment grade” and one is “junk.” Who gave these firms the right to determine this and how is it determined?
What this all means is that we see continued pricing inefficiencies in single B and CCC credits as most investors avoid them given their perceived “risk.” For a much more detailed discussion on this, please see our piece “The New Case for High Yield.”
As a reminder, Ron Heller, CEO of Peritus, will be a guest on Fox Business Network’s “After the Bell” on Tuesday, July 29th at 4pm ET. Ron will also be featured on the ETF Store Show on Tuesday, July 29th at 9am CT.
Ron Heller, CEO of Peritus, will be a guest on Fox Business Network’s “After the Bell” on Tuesday, July 29th at 4pm ET.
High Yield investors should understand the difference between an index-based product and its yield generation characteristics and portfolio composition based on the underlying index, versus some of the expanded opportunities available to active managers. For instance in the high yield bond and bank loan space, we see index-based, passive products that are largely high yield bonds or largely floating rate bank loans, not a blend of each.
At Peritus, in addition to our core high yield bond holdings in our portfolios, we have the flexibility to capitalize on opportunities in dividend paying equities and floating rate loans. We see this as an advantage as it allows us to invest up and down a company’s capital structure in terms of the security that we see the best from a risk/return perspective. Additionally, this dramatically increases our investment universe and has a secondary benefit of reducing the portfolio’s duration.
We have two very specific focuses with our equity investments. The first is related to thematic investing. Though our themes will continue to evolve and change, the equity component in our portfolio is there to help execute on what we call “price to conviction.” This means that we may have a very high degree of conviction on our particular theme and, in some cases, want to execute on this concept with the highest rate of return security available, which could be a dividend paying equity.
In today’s environment, this involves our energy theme. We are looking to take advantage of what we feel are sustained high prices for oil and natural gas. Companies operating in the Western Canadian Sedimentary Basin have much different (sustainable) production profiles than many in the shale basins in the US. Several things are important to note: because Canada has a very nascent high yield market, companies often need the equity market to raise capital. As such, many of these companies may pay out significant yields to attract investors and treat their dividends like interest payments. They recognize that their dividend payments are sacrosanct and will adjust capital expenditures rather than cut their dividends. And given the lack of substantial debt, we see the enterprise value through the equity as attractive in certain cases.
The second specific equity focus involves seeking to take advantage of the recent wave of refinancings for high yield companies. We have stated that we are capital structure agnostic. In this case, we have seen a number of companies refinance their bonds some 3.00% cheaper, or even more. The interest savings flows down the capital structure, with additional cash flow generation to the benefit of the equity. So the dividend is further enhanced/protected by this interest savings and in some cases our determination is the equity becomes the best risk/return part of the capital structure.
On the loan side, we see the biggest benefit being that there are companies that issue only loans and not bonds. In some cases, these loans offer what we see as very attractive yield and by having the flexibility to include both bonds and loans, we are able to take advantage of these opportunities; rather than just being limited to those bond-issuing companies. Furthermore, as we noted above, because of the floating rate nature, where-by rates can reset every three months, this can have a secondary benefit of reducing the portfolio’s duration.
We see that having this sort of flexibility on both the loan and equity side, above and beyond our core high yield bond holdings, as allowing us to expand the opportunity set for yield-bearing securities, giving us more flexibility in a given market cycle and environment, and allowing us to work to maximize alpha.